Fed Model Update

Periodically, we update our version of the so-called “Fed Model” to provide a picture of how current US stock market valuation compares to Treasury yields from a historical perspective.  Traditionally, the Fed Model takes the trailing twelve month P/E ratio for the S&P 500, inverts it to get what’s known as the “earnings yield” then takes the ratio of the earnings yield to the yield for the 10-year US Treasury bond.  Theoretically, the higher the ratio, the more undervalued the market is and vice versa.  There have been many justifiable criticisms of the traditional Fed Model, many due to the fact that the traditional Fed Model has been an imperfect predictor of future stock market out and under performance.  We think some of this has to do with the traditional volatility of the trailing twelve month P/E ratio, which can jiggle violently during times of major movements in price and underlying earnings, especially when earnings completely fall out of bed.

To combat this issue, we substitute Shiller’s 10-year CAPE P/E for the trailing twelve month ratio as the “E” in the longer-term version is much more stable.  The longer term chart for this indicator follows:

As you can see, using +/- 1 standard deviation bands as a guide, the model has performed reasonably well in signaling severe under and over valuation turning points, especially on the undervaluation side.  A move above the range in early 1962 (undervaluation) presaged a strong move higher in markets for the next several years.  Similarly, the move above the standard deviation range during the market lows of 1974 proved to be a decent point for what would become a bull market rally lasting until 2000, which is where extreme overvaluation levels were reached (though in fairness it took until 1982 for the bull market to begin in earnest).  The model again signaled extreme undervaluation levels in the wake of the financial crisis in late 2008.  Since that time, the model has remained in severe undervaluation territory, primarily due to the fact that 10-year Treasury yields remain so low.  During that time, US markets have tripled off the lows on a nominal return basis and performed even better when dividends are taken into account.  

As of now, owing to the continued low bond yields, the model remains in undervalued territory, despite the fact that long-term CAPE P/E ratio is reaching very extended levels.  Many observers would argue that the model is “broken” due to the outsized influence of extraordinary Federal Reserve policy on long-term interest rates.  Over the past several years, however, markets have continued to move higher validating the signal, even though it’s been “distorted.”  

The signal could move out of undervalued territory one of several ways.  A strong spike in Treasury yields would of course push the ratio down all things being equal.  Or, for better or worse, the market could take off to the upside recreating the extreme CAPE valuation bubble scenario observed in 1999 and 2000.  Or, certainly, one could get a strong combination of the two.  

So what happens going forward?  Is this a broken, or meaningless indicator?  Perhaps, using a revised version of the Fed Model could help provide some additional perspective.  Instead of using 10-year Treasuries, we’ve also recreated the Fed Model using long-term investment grade bond yields.  Here is the Fed Model with that adjustment:

This version doesn’t show the same extreme in undervaluation as our “traditional” model, but it’s still near the top of the range observed over the past few decades.  

All things considered, these Fed models add to other pieces of evidence that suggest it may be a mistake to write off the bull market in US stocks just yet.  While US markets are certainly overvalued using the long-term CAPE PEs as a guide, long-term momentum remains comfortably intact, and forward-looking economic models continue to show very low probability for a US recession in coming months.  As we’ve discussed in the past, the most devastating bear markets over the past century have occurred when markets face a devastating combination of extreme overvaluation, deteriorating intermediate to long-term momentum, and a strong deterioration in forward-looking economic indices, such as the Conference Board leading indicators, showing high probabilities of future recession and earnings dislocation.  Right now, two out of three of our indicators are in green territory.  The Fed Models aren’t necessarily the so-called “end all and be all.” But, they’re matching with other indicators, which makes the models hard to ignore, especially since they’ve performed reasonably well as action triggers across several distinct economic periods during the past 50 years.   

Oil Price Decline: Secondary Effects

The financial world has focused much attention on oil markets in recent weeks, and rightfully so.  Brent crude and WTI prices have fallen nearly 50% since summer.  This afternoon, WTI has closed below $58 per barrel for the first time since May 2009.  Obviously, this has enormous impacts on oil industry equities, not to mention the biggest oil-producing countries around the world, at least in the intermediate term.  Levered oil service and extraction plays have seen 50% plus declines in stock prices.  Russia, Venezuela, and a host of other countries have begun to experience severe macroeconomic and market stress due to the price declines.  Meanwhile, the effects on the rapidly expanding shale play in the US and Canada haven’t become fully apparent yet.  It’s safe to say, though, that these price declines will start to severely impact future capital spending in the US and Canadian oil spaces.

Just as importantly, the move in oil is beginning to impact other markets and expectations.  Very quickly, we’ll point out a few instances where the impact of oil’s decline is filtering through global markets.

First, let’s take a look at US high-yield bond markets.  As we pointed out earlier this year, high-yield spreads had narrowed to levels unseen since the pre-2007 crisis days reflecting the general high optimism in global markets and investors search for yield.  Now we’re coming to find out that a solid portion of high-yield issuance in the US was related to the emerging oil boom here.  With oil prices cratering, heavily levered oil-related companies are finding their margin for error in terms of debt service rapidly eroding.  This is beginning to influence overall yields and yield spreads relative to Treasuries.  As you can see below, since oil started declining this past summer, yield spreads relative to Treasuries have jumped approximately 200 basis points.  The absolute yield as represented by the Bloomberg High Yield has jumped by nearly 150 basis points over that time period.  While the spread relative to Treasuries is certainly nowhere near the levels associated with crisis (look at the spike in ‘08/’09), there’s been a quick resetting of expectations in the high yield market in line with oil’s declines.

Next, let’s take a look at market inflation expectations globally (below).  Global central banks now have quite a dilemma on their hands, especially the Federal Reserve and the European Central Bank.  Not too dissimilar to the oil spike in ‘07/’08 sowing confusion among central bankers as to the true path of inflation, central bankers now have some tough decisions to make on future policy as expectations for inflation in the US and Europe have dropped dramatically in line with the collapse in oil.  In the US, for instance, QE3 has been effectively wrapped up, economic data has looked strong, and Federal Reserve officials are talking potential rate hikes by mid-2015.  Meanwhile, 10-Year US Treasury yields are hurtling back towards the 2% level and inflation expectations 5 and 10 years forward are falling back to levels last seen during the crisis.  In Europe, persistent economic weakness has pressured price levels for the past few years; even without the new oil price variable, it’s clear that Europe is treading very close to outright deflation, a strongly negative situation from an economic perspective.  Now with oil falling, inflation expectations have accelerated to the downside, perhaps adding to the urgency of the situation.  Accordingly, Mario Draghi and his colleagues at the ECB are mulling much more forceful action, German reluctance be damned.  How do central bankers incorporate oil’s price influence on overall inflation/deflation?  Remember, in the US pre-crisis, the Fed erred by letting commodity price inflation hold them back from acting more forcefully sooner to counter the growing economic problems.  In this case, does a depressed oil price and headline inflation number keep the Fed from acting quickly enough to address a rapidly improving labor market?  Draghi’s situation is a bit more clear cut—core inflation is on a harrowing downward trajectory too--but these new variables certainly make discussions among numerous stakeholders much more difficult.  

Europe 5-Year, 5-Year EUR Inflation Swap Rate (Future Inflation Expectation)

Source: Bloomberg

Again, we see a situation where action in one market begins exerting significant influence on situations elsewhere, and more rapidly than investors and policymakers are prepared to react.  Oil’s price declines are good for many of the world’s consumers, of course, but they create numerous complications for investors and policymakers across asset classes in many of the developed countries.

What Happens After Big Upside Reversals?

The past month has presented a seemingly extraordinary situation in the markets with the S&P 500 at one point falling nearly 10%, then recovering to significant new highs within weeks.  Some observers view the move as unsustainable and a sign that significant trouble still lurks ahead for markets.  We thought it would be interesting to see how the S&P 500 has actually performed historically in the wake of sharp v-shaped reversals like the one we just witnessed.

First, we needed to come up with a precise definition of what constitutes a sharp upside reversal.  Please bear with us here.  To start, we calculated the mean difference between the S&P 500’s daily closing price and the daily 50-day trailing moving average since 1955.  We then calculated the standard deviation statistic for that mean difference.  For the uninitiated, standard deviation gives us a sense statistically of how significant a move has occurred below or above a mean.  For instance, under a normal “bell curve” approximately 66% of outcomes should be with + or – 1 standard deviation of the mean and approximately 95% should be within + or – 2 standard deviations of the mean. In this case, we looked for all trading days since 1955 in which the number of standard deviations from the mean (also known as a “z-score”) in terms of distance from the 50-day moving average was 2 or more z-score points above the z-score from 25 days prior (basically 5 trading weeks).  In other words, if the S&P 500 closed 2 standard deviations below the 50-day moving average five weeks ago, and closed 1 standard deviation above the 50-day moving average today, that would count as a reversal (the z-score difference would be 3 in this example).  

As others have observed, this turns out to be a somewhat rare occurrence.  Overall, there were 14,993 trading days in our sample.  703 days, or 4.7%, met the criteria set out above for a significant upside reversal close.  Keep in mind though that these days tend to cluster in bunches, so there can be long periods of time between market periods exhibiting this type of behavior.  

How does the market perform, on average, in the wake of these upside reversals?  Quite well actually.  It appears that the good performance carries on.  We looked at performance 90 trading days, 270 trading days, and 540 trading days from a reversal trigger day.  The data is below.  

As you can see, for each of the three time intervals, short-term to long-term, the average performance following reversal trigger days was higher than normal.  The difference in average performance is statistically significant for all three time-intervals at the 99% level.  And, for the 90 and 270-day time intervals, the percentage of negative outcomes after reversals was solidly lower than for the overall data set.  At the 540-day interval, the percentage of negative outcomes was slightly higher.  

Does this mean the market is guaranteed to jump 10% to 20% over the next year or so now that we’ve observed a sharp upside reversal period?  Of course not.  As one would expect, there were plenty of negative results to be found in these data sets, with the ‘73/’74, ‘00/’02 and ‘07/’09 mega bear periods providing some particularly gory outcomes.  Nonetheless, the outcomes show that volatile reversals of the sort we just observed in recent weeks more often lead to periods of significantly better than normal performance moving forward instead of major pain, especially when the reversals happen in the middle of a benign economic and market performance period.  If we see reversal events like this crop up in conjunction with deterioration in the overall fundamental market and economic backdrop, we’ll begin to raise our eyebrows, though.

What’s Working Globally: Sector Relative Strength Overview

A few weeks ago, we discussed the fact that EAFE markets had reached record relative strength lows vs. US markets.  This week, taking the relative strength work in a different direction, we look at which sectors in the MSCI World index have been outperforming and which have been lagging, perhaps giving us a little extra insight into overall market direction.

First, here are the relative strength charts for each sector index relative to the overall MSCI World index.  Upward sloping lines show relative outperformance; downward sloping lines show relative underperformance.  We’ve added a 30-week moving average for the ratio to help with the trend visual.

From the above we see the following sectors currently displaying relative strength ratios above the 30-week moving average:

• Consumer Discretionary (But barely—the trend has been down this year)
• Consumer Staples
• Information Technology
• Health Care
• Utilities
• Telecom Services

The following ratios have fallen below the 30-week moving average:

• Materials
• Financials
• Energy
• Industrials

It should be noted that the Consumer Discretionary sector has struggled on a relative basis for most of the year following a long period of outperformance off the 2009 lows and has barely moved back above the trendline.  We’d continue to classify this sector as residing in a “danger zone” even though it’s acted better recently.  

What are some other off-the-cuff observations?

• Move Consumer Discretionary into the “weaker” camp as discussed above and we get an overall picture of economically sensitive sectors lagging while the traditionally “defensive” sectors display relative strength.  The recent rally off the correction lows hasn’t meaningfully changed this dynamic.  Yes, relative strength in sectors like Industrials and Consumer Discretionary have outperformed in recent weeks, but remains well off the levels observed at the beginning of the year.  We know the US specifically is performing well economically.  The “defensive beating sensitive” dynamic in global indices, however, reflects the spotty economic situation observed this year in Europe and Asia.  Subdued demand from mainland China hasn’t helped (see Materials and Energy below, for instance).
• From approximately 2000 to 2008, the relative strength ratios for the Energy and Materials sectors nearly tripled.  After nearly a decade of outstanding relative outperformance, Energy and Materials names have been really tough relative investments over the past several years, as one might expect after a strong run.  The recent significant price declines in oil and other commodity markets have accelerated the underperformance trends. Looking at the charts, relative strength support levels have been broken and there seems to be little reason at this point why this situation should change meaningfully anytime soon. The Energy sector looks particularly vulnerable.
• Ditto for global Financial stocks. Overall, Financial companies haven’t been able to get out of their own way since the beginning of 2010.  Global economic weakness, scandals (Forex-rigging fines provide the latest examples), and other factors have kept them stuck in the mud.  If and when these companies regain their footing from a regulatory, management, and economic standpoint, there’s significant room for upside here though.  
• Telecom Services have been a performance wasteland since the heady days at the end of the tech/telecom boom of the late 1990s, despite the fact the globe has witnessed an amazing transformation and expansion in global telecom and data networks.  Overcapacity and debt hangovers following the late 90s party have morphed into other issues, such as heavy investment requirements for new networks and low returns on that invested capital, competition, and saturation.  Against this backdrop, it’s easy to understand global telecoms’ reticence to embrace “net neutrality.”  Fundamentally, it’s hard at this point to see why this sector can break out to the upside on a relative performance basis.  Like financials, though, if these companies can get it together, there’s plenty of room to run.
• In contrast, the broader Information Technology sector is starting to show some solid relative strength after a 10-year period of market-matching performance.  While many investors have spent considerable energy following Apple, some of the old-school large-cap tech names like Microsoft and Intel, which have considerable influence over overall sector performance, have quietly demonstrated strong performance this year after trading sideways for much of the past decade.
• Health Care refuses to slow down.  Over the past two decades, Health Care has been the biggest outperformer in the MSCI World.  Demographic change, ever-rising health care costs and spending, and initiatives like the ACA have propelled health care higher at various stages in the cycle.  As seen with sectors like Energy, IT, and Telecom at various points in time, strong spikes higher in relative strength have often been followed by hangovers.  Health Care isn’t showing any cracks right now.  This sector will be interesting to watch in coming years, though, as governments and consumers look to put a lid on health-care costs.
• Here’s a final interesting tidbit.  Since 1995, the global Consumer Staples index has outperformed the Consumer Discretionary index significantly (347% to 204%).  Considering the fact the world has seen hundreds of millions of people from emerging markets such as China enter global consumption channels, and that consumer debt in developed economies increased significantly over that time period, we find it somewhat surprising that performance has accrued to consumer “needs” over consumer “wants.” 

Investing Based on Emotion, Ideology, Frenzies, or Fads: Just Don’t Do It

A friendly reminder.  Making asset allocation decisions based upon emotion, ideology, political inclination, commercials you hear on CNBC, market fads and frenzies, and other similar justifications is a quick way to the House of Long-Term Investing Frustration.  Yet, time and time again investors fall prey to the quick sell.  We’ve mentioned the emerging market performance issues over the past five years.  Another recent source of frustration for many?  Gold.

A few months ago we pointed out that there had been a material trend shift over the past few years in the Gold price to S&P 500 relative strength ratio, and the Gold price to US Dollar Index ratio.  Since that time, the damage in precious metal prices, and commodities in general, has continued.  Three rounds of quantitative easing have come and gone since 2010.  The Bank of Japan embarked on an aggressive, ambitious new monetary reflation program in late 2012 that’s continued mostly unabated to this day.  Then, last night, they announced an even more aggressive roadmap.  What happens?  Gold prices fall to new multiyear lows today.

We’ve all seen the ads on TV, heard the frightful commercials on the radio, and listened to the gold bug pundits on the talk shows discussing how everything from the Federal Reserve’s programs in 2010, 2011, and 2012 to Obama’s reelection in 2012 was going to be the death knell for civilization as we know it.  Instead, gold markets have observed 30%+ price declines since the election of 2012 while equity and other risk markets have moved materially higher.  Prices have cruised through trend lines like the Germans through the French Maginot Line.

Here are some updates on the relative strength charts mentioned above:

Yes, Gold had a phenomenal move during the years leading up to and through the financial crisis, relative to equity markets and the dollar in general.  However, and unfortunately, the mass of individual investors and those catering to them didn’t catch the bulk of that move.  Much capital was invested at or near the peaks of these relative strength charts.  There will certainly be “back and fill” moves going forward, but these moves have tended to carry on for years.  We continue to believe that the gold price will struggle for a while longer.

What’s are some quick lessons?

Conventional wisdom is nearly always the big loser when it comes to investing.  There’s a broad range of research showing that individuals and institutions alike are strikingly terrible at timing the big moves among various risk assets.  The past 15 to 20 years have provided some particularly painful examples.  Looking at the relative strength charts above, notice that the peak of the S&P/Gold relative strength chart and the nadir of the Gold/Dollar chart, coincided with the peak of the tech stock boom and broader secular bull market in 1999/2000.  Back then, stocks were promoted as far as the eye could see (remember the online brokerage commercial where the teenager takes off in a helicopter) while gold was a complete afterthought.  Within months, the trends highlighted above changed dramatically.  The subsequent 10 years ushered in a brutally frustrating secular bear market in stocks and resurgence in gold and commodity prices.  Likewise, as we’ve pointed out numerous times, a similar phenomenon occurred with Emerging Market equities.  Almost entirely shunned at the turn of the century, emerging market stocks outperformed significantly from 1999 to 2010.  At approximately the same time the pundits and analysts were telling us that gold was ready to rocket to $3000 or even $8000/oz, investors were bombarded with reports that emerging market equities, particularly the so-called BRICs were ready to trounce the developed markets for years to come.  Instead, over the past five years, even diseased European markets have outperformed broader emerging markets by a solid margin.

Piggybacking on the conventional wisdom talk, we can draw an ultimate lesson: value and reversion to the mean usually win out in the long run.  

Admittedly, for many, it can be difficult to identify areas of the broader marketplace showing value.  Not everyone has access to valuation databases and nifty charts, nor do many people have the time to engage in this type of analysis.  Access to investing platforms is easy, though, especially when there are thousands upon thousands of specialized ETFs and mutual funds to choose from.  Somewhat counter intuitively, this can be dangerous to one’s financial health.  Innate behavioral biases virtually assure that emotional investors are going to get drawn to the “shiny light” products.  Unfortunately, the opportunistic carnival barkers don’t usually show up until much of the move in the “shiny object” has already occurred and valuations are out of sorts.  With numerous products to choose from, inexperienced investors, and even experienced ones, now have ample opportunity to follow the herd and end up in performance killing corners of the universe.

What’s the simple solution?  For most, diversification with mechanical, emotionless rebalancing at specified time intervals back to target portfolio weights eliminates a good portion of the problem.  Of course, people need to make sure that the target weights themselves in a portfolio aren’t subject to political or economic biases.  Crafting a financial plan in 2010 and deciding that an appropriate target weight for metals was 75%, for instance, would’ve been an unfortunate expression of “diversification.”  

So, where are some potential value areas around the world now in equities?  We pointed out last week that valuations in overseas developed and emerging equity indices are now trading at the biggest discounts to the S&P 500 observed at any time over the past decade.  Relative strength charts for developed overseas markets show near-historic underperformance for EAFE equities relative to US stocks.  We’ll venture a guess that at some point in the coming months or years, markets will observe a dramatic reversal in relative performance between US and international equities.  It may be sooner, it may be later, but it will happen at some point in a fashion reminiscent of the turns in gold/equities and emerging markets/developed markets sentiment at various points over the past two decades.  Turns like these typically occur at points of maximum pessimism/optimism and, hence, are ignored by the vast majority of investors.  As is the ongoing nature of the game, we have little doubt that most investors will miss the next big turn in the world of relative returns.

Mind the (International) Gap

Over the past two weeks, the US-focused S&P 500 has been on a wild roller-coaster ride.  After falling nearly 10% from the late summer peak, the index has recouped over two-thirds of the losses and reestablished a position in the middle of the 1925 to 2000 trading range that’s prevailed since early summer.  

The MSCI EAFE, an index composed of stocks from Europe, Australia, and the developed Far East, presents a vastly different story.  During the current correction, the EAFE declined approximately 15% peak to trough and has only recovered about 4% during the recent bounce.  Similarly, the MSCI Emerging Markets index, which showed promise earlier in the year, fell over 12% peak to trough and has barely rallied back during the recent move higher in global equities off the lows.  

The large performance gap between US equities and international equities, both developed and emerging market, has been an issue for five years running.  From the end of 2009 through 10/23/14, the S&P 500 has nearly doubled, up 93%.  In contrast, the MSCI EAFE is up 33.7% and the Emerging Market index is up a paltry 13.54% total.  Wow, talk about turning conventional wisdom on its head!  Few talking heads in 2009 would have predicted that the US would so handily beat emerging markets over the ensuing five years. 

We’ve pointed out in the past how relative strength between the various indices tends to trend for long periods of time.  Let’s take a quick look at the long-term relative strength charts for the S&P 500 vs. the EAFE and the S&P 500 vs. the MSCI Emerging Markets Index.

Since the formation of the EAFE Index in the early-1970s, under and outperformance trends appear to run in 20-year cycles.  The EAFE, running on the back of a strong Japanese equity rally, significantly outperformed the S&P 500 from the early 1970s until the early 1990s.  Since then, except for a brief period of outperformance in the mid-2000s, the S&P 500 has maintained the upper hand.  With the recent relative underperformance of the EAFE, generally associated with the continued economic and market malaise in Europe, the EAFE/SPX relative strength index has now fallen to levels not observed since the early 1970s.  The post-financial crisis years have not been kind at all to developed international equity markets.

As seen above, the over and underperformance cycles for emerging market equities have run at shorter time intervals (approximately 10 years).  Emerging market equities had a strong run in the 1990s until crises in the back half of the decade, notably the Asian and Russian financial crises, seriously dented money flows into emerging markets.  During the decade up to and through the global financial crisis, we see significant outperformance reflecting the general “emerging market miracle” economic outperformance observed during that period.  Since then, the ratio has dropped like a stone and remains comfortably below the long-term moving average.  

If there’s a silver lining to the relative strength story, past moves through the +1 or -1 standard deviation bands have been precursors to future trend changes.  In this case, there may be some light at the end of the tunnel for EAFE stocks.  If past experience is any guide, however, emerging market stocks may have to experience more relative performance pain before they regain their footing.  

Adding long-term valuation to the analysis potentially adds another silver lining for international markets.  Currently the EAFE and the Emerging Market indices are trading a solid discounts to the S&P 500 when using 10-year, cyclically adjusted P/E ratios.  The S&P 500 is currently trading at 21.7x cyclically adjusted pro-forma earnings, nearly 1 standard deviation above the long-term median of 16.4x.  Alternately, the EAFE is trading at approximately 15.9x, below the long-term median, and the Emerging Market index is trading at 12.3x, the lowest levels since the financial crisis.  Moreover, the ratio of the S&P 500 P/E ratio to both the EAFE and Emerging Market P/E ratios is at the highest levels observed over the past decade.  The valuation divergence has become as significant as the performance divergence.

CAPE PE ratios in isolation have been solid predictors of future 10-year performance regardless of the overall qualitative economic and investing environments across regions.  Again, if valuation history is any guide, odds seem to favor a reversal in the relative performance trends in the coming years.  The valuation ratio charts for the three indices are presented below.

It’s been a rough stretch over the past half decade to be a international investor.  We’ve been waiting for quite a while to see some turn around in the relative performance situation for international stocks.  Until we see the relative performance ratios stabilize and move comfortably through the long-term moving averages, we’re not ready to call the end of the underperformance cycle.  Looking at overall valuation and relative valuation, however, gives us some encouragement that international markets are on the cusp of a performance shift.

Visualizing Recent Volatility:

After a three-year stretch of significantly lower than average volatility in global markets, the volatility spirits rediscovered their mojo in recent weeks.  Instead of jumping on a crowded bandwagon and examining and reexamining all of the reasons “why” global markets have entered correction territory, we thought it might be interesting to provide some visuals that show how quickly greed turned to fear in risk markets and show how the fear associated with the recent correction compares to past episodes.  As you will see below, and as we’ve pointed out in the past in various venues, though markets have displayed signs of complacency at various points during this uptrend, market participants have been very quick to jump to pessimistic extremes at the first signs of market distress, even though the overall corrections are minor in scope relative to past speed bumps.  

Let’s look through some of the charts.

First, let’s look at the truest representation of market volatility, realized volatility in the S&P 500 and MSCI EAFE in recent days and weeks.  We accomplish this by taking the 20-day standard deviation of daily market percentage moves.  Simply, higher standard deviation numbers mean dispersion or volatility in the daily performance numbers over the trailing 20-day period has increased.  We’ve included a chart of 20-day standard deviation that covers 1958 to the present.  You’ll see below that in recent months, volatility hovered around the lowest levels ever observed in the data series for both the EAFE and the S&P 500.  As bad as recent action has felt, however, the recent turmoil has barely taken actual volatility for the S&P 500 above its long-term average.  Interestingly, despite the fact that the MSCI EAFE has corrected far more than the US-specific S&P 500, EAFE realized volatility remains below the historical average.  Realized volatility for both indices hasn’t even scratched the surface of the volatility observed during the 2011 European debt crisis.  Overall, it’s felt like a wild ride in recent weeks, but only because our collective perceptions have been warped by the extended period of unusually low volatility.

The overall corrections have been contained thus far by historical (or even recent) standards, and realized volatility, as we’ve seen above, hasn’t really come close to touching levels observed during past corrections.   How’s psychology holding up?  Traders and investors wilted pretty quickly out there.  Let’s look at three different gauges that help measure investor psychology: the CBOE put/call ratio, the ISES Sentiment Chart, and the relationship between the VIX and VXX volatility measures.  

The CBOE put/call ratio spent the early part of this year near the lowest levels observed over the past decade (higher levels indicate more put activity relative to calls, hence more fear).  With the recent correction, the 10-day average for the put/call ratio quickly rebounded to levels nearly 2 standard deviations above the average going back to 1995.  

We see a more dramatic story in the ISES indicator, which also measures put activity relative to calls.  This indicator operates in reverse; lower levels indicate more fear in the markets.  Here, the 10-day average for the indicator has reached levels not observed since the depths of the financial crisis in 2008/2009.  As recently as early September, the ISES was approximately 1 standard deviation above the longer-term average.  Now, it’s reached levels approximately 2 standard deviations below the norm.  By this indicator, overall fear in the market is significantly disproportionate to the actual disruptions taking place in the broader markets and the magnitude of the change in market fear over such a short time frame is dramatic when considered against the overall market backdrop.  At this point, it appears that traders have been overemotional.   

Next, let’s look at the relationship of the VIX Index to the VXV Index.  The VIX measures 30-day implied volatility for at the money S&P 100 index options.  The VIX is probably the most widely followed “fear gauge” in the marketplace.  The VXV, a cousin of the VIX, measures 90-day implied volatility.  During normal periods, the longer term implied volatility as measured by the VXV is lower than shorter term implied volatility as measured by the VIX.  During periods of market fear, this relationship is upended with near term-implied volatility spiking past longer-term volatility.  We see below that the VIX:VXV relationship reached levels this week that haven’t been observed since the Europe-induced correction of 2011.  Despite the fact this correction (to this point) is roughly equal in terms of magnitude to the corrections experienced during the summer of 2013 and early summer 2012, this fear gauge, like the ISES above, is acting as if a much greater calamity has taken place.  

Are the recent gyrations the first shots across the bow in advance of much bigger market problems?  Granted, just because spikes in fear gauges have outpaced the actual disruptions in the markets doesn’t necessarily mean all is well, the contrarian stabilizers are ready to kick in, and that markets are going to resume their march ever higher.  For instance, we can look at the charts above and see that the fear gauges spiked to levels near current levels at the beginning of 2007 and remained at those levels, even though the worst parts of the market calamity and financial crisis didn’t arrive for another year to year and a half.  Yes, some of those extreme fear levels triggered some large upward counter-rallies throughout 2007 and 2008, but they turned out to be small drops in the bucket compared to the large downward moves taking place during that time period.

At this point, our work still suggests there’s no reason to believe that the current market correction is ready to morph into anything akin to the problems experienced globally in 2008/2009, or from 2000 to 2002.  While leading economic indicators in Europe and Japan are becoming problematic, similar to early/mid 2011, the US and other regions continue to show very little risk of imminent recession.  Yes, intermediate to longer-term market technical indicators have broken down again in Europe.  The upward story, however, remains intact to this point in the US and Japan.  Valuation is above average in the US on a longer-term basis using adjusted CAPE measures, but not at the levels observed in 2007.  As such, we believe the worst-case scenario at present is a correction similar to the ones experienced in 2010 and 2011.  Those corrections were certainly painful in the short-term but proved to be short-duration setbacks within the larger uptrend.  Against that risk scenario, we hold the view that investors have overreacted to this correction in a manner similar to overreactions observed in May-2012, Fall-2011, and spring-2010.

Of course, if the data changes, we reserve the right to change our minds.  We’ll be the first to shout from the rooftops if anything in the model changes suggesting that something much more momentous and dangerous is on tap for investors.